Euro area, United Kingdom
Our economic and market outlook at midyear 2023
June 26, 2023
The euro area economy contracted in the fourth quarter of 2022 and the first quarter of 2023. We expect growth to resume but the expansion to be short-lived. A new downturn is likely to arrive this year or next. In the United Kingdom, marginal growth has continued, but there, too, we anticipate recession, as well as higher rates of inflation than on the continent.
Read video transcript
Jumana Saleheen: The trajectories for the euro area and the United Kingdom economies have played out largely as we envisioned in the Vanguard Economic and Market Outlook for 2023. High inflation has required higher central bank policy interest rates and has constrained growth.
What has surprised us is the degree of resilience we’ve seen, especially in the labor markets and inflation. Inflation has been stickier than we expected and has required the European Central Bank and the Bank of England to raise policy interest rates higher than we had anticipated.
Inflation has been especially sticky in the United Kingdom. Headline inflation appears to have peaked now, despite troubling high food prices, but core inflation has continued to rise higher, driven by persistently strong demand for services amid relatively high wage growth.
In the euro area, the war in Ukraine sent energy prices soaring last year. That has taken a toll on the region, sending the euro area into recession in the first quarter of 2023. However, the fall in natural gas prices since the start of this year to levels seen around 18 months ago has been welcome news. It has boosted optimism and resilience in the near-term economic outlook for both the euro area and the U.K.
But the inflation challenges remain, and the interest rate increases required to get inflation back to target are likely to weigh on growth from this point onwards. We don’t anticipate interest rate cuts until well into 2024 in either the euro area or the U.K.
And that’s because it takes time for those higher interest rates to effectively reduce demand by limiting the amount of money and credit in an economy. In areas including the U.K. mortgage market, this transmission is taking longer than in previous cycles. But make no mistake, the transmission of monetary policy is happening slowly but surely. Labor markets are starting to show signs of loosening across Europe.
The inflation outlook brightens through 2024. We see both headline and core inflation falling back towards ECB and Bank of England target levels, allowing for a loosening of interest rates and supporting a modest pickup in growth.
Euro area
Our outlook for year-end 2023
0.5%
Economic growth,
year-over-year
We believe the energy crisis drove the shallow 2022–2023 contraction. A muted recovery is likely before the lagged effects of monetary policy tightening trigger a new downturn. The peak impact of European Central Bank (ECB) interest rate hikes will occur in the second half of 2023, lowering output.
3.3%
Core inflation, year-over-year
By any measure, inflation has declined meaningfully. Falling energy prices should help the headline inflation rate to further ease in coming months. Food prices are past their peak, too. Neither are included in the trend-revealing core rate. Service-price inflation, linked to wage growth, is stickier and central to our expectation that core inflation will end 2023 at 3.3%, still well above the ECB’s 2% target.
3.75%–4%
Monetary policy rate
The ECB has hiked interest rates by 400 basis points (4 percentage points) in 12 months. We expect one or two additional increases. A deposit rate of 3.75%–4% would represent a restrictive policy stance.* It would exceed our inflation forecast and be more than twice our 1.5%–2% estimate of the region’s neutral rate of interest, a theoretical rate that neither stimulates nor inhibits growth.
7%–7.5%
Unemployment rate
After peaking in 2020 at 8.6% amid the COVID-19 pandemic, the unemployment rate eased to 6.5% in April 2023. We foresee a partial retracement in the second half of 2023 as the ECB’s inflation-fighting campaign passes the one-year mark and the lagged effects of changes in monetary policy are fully revealed.
What I’m watching
Euro area wage growth likely to peak at year-end 2023
“More than half the rise in euro area inflation in 2021 and 2022 owed to corporate profit growth. We expect workers’ pay to play a bigger role in setting the rate of inflation in the coming months. Even so, year-over-year wage growth is likely to decline sharply in 2024 amid declining inflation expectations and weakness in the labor market.”
Shaan Raithatha,
Vanguard Senior Economist
Notes: Proprietary Vanguard forecasts of euro area wage growth from the beginning of 2023 to the end of 2027 are based on quarterly government-reported data from the second quarter of 2009 through the fourth quarter of 2022. Data reflect year-over-year changes. Net demand for labor reflects gross demand for labor minus supply of labor. Positive net demand boosts wages and vice versa.
Sources: Vanguard calculations, based on data from Eurostat and Bloomberg.
United Kingdom
Our outlook for year-end 2023
0%
Economic growth,
year-over-year
As in other markets, we’ve been surprised by the resilience of the U.K. economy. Our initial forecast of a 2023 contraction in the production of goods and services has given way to an estimate of no change in output. As elsewhere, we believe a recession remains more likely than a soft landing.
4.9%
Core inflation, year-over-year
Strengthening services inflation has driven core inflation to more than 30-year highs, whereas core inflation is retreating in many other developed markets. We expect core services inflation to drive broader headline inflation in the year ahead as prices for food, energy, and other goods wane.
5.5%–5.75%
Monetary policy rate
We’ve recently raised our forecast for the Bank of England’s terminal rate by three-quarters of a percentage point given stronger-than-expected inflation data, the continued tight labor market and accelerating wage growth. We maintain our view of no rate cuts until mid-2024 at the earliest.
4–4.5%
Unemployment rate
By a variety of measures, notably rates of employment and wage growth, the labor market displayed strength in the opening months of 2023. Yet consumers have not been confident about future employment. We expect a modest rise in unemployment in the second half of the year.
What I’m watching
Stubborn core inflation
“Over the last two months, core inflation has accelerated, in stark contrast to the euro area and the United States, where rates appear to have peaked. Particularly concerning is that core pressures seem to be driven by strengthening services inflation. With the labor market still tight, the Bank of England likely has some hard work still to do to guide inflation back toward its 2% target.”
Shaan Raithatha,
Vanguard Senior Economist
Accelerating core inflation
Notes: Chart shows changes in the core consumer price index for all locations.
Sources: Vanguard calculations, using data as of June 21, 2023, from the U.S. Bureau of Labor Statistics, Eurostat, and the U.K. Office for National Statistics.
The outlook for emerging markets
The challenges facing the euro area and the United Kingdom are magnified in developing Europe. We expect growth of around 1% in 2023 and just below that level in 2024 in the greater Central Europe and Africa regions and core inflation to remain in double digits.
* The deposit rate is the annualized rate of interest paid by the ECB on banks’ overnight deposits.
Notes: All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future results.
A closer look
Asia-Pacific
China’s and Australia’s economies share one attribute: Growth slowdowns are likely.
10-year asset-class returns
Our 10-year annualized return forecasts are modestly lower since the start of the year for most developed markets.
Inflation and portfolios
Even in the unlikely event of long-term elevated inflation, a 60/40 portfolio could serve investors well.